In order to understand how a tankless water heater works, it's important to know how a standard tank heater operates. In a traditional heater system, there's a large tank that holds and heats water. In order to give you hot water when you need it, the tank continually heats the water to maintain a constant temperature. The energy used to keep the water hot even when it's not being used is called standby heat loss. You can get more information about tank heaters in How Water Heaters Work.
Tankless systems avoid standby loss by heating incoming water only as you need it -- they're also referred to as "on demand" water heaters for this reason. The elimination of the standby heat loss is what makes a tankless system more efficient, but we'll get to that in more detail a little later.
In order to get you that piping-hot shower when you want it, a tankless water heater uses a powerful heat exchanger to raise the temperature. A heat exchanger is a device that transfers heat from one source to another. There are heat exchangers in your air conditioner, refrigerator and car radiator. In this case, it transfers heat generated by electric coils or a gas-fired burner to the water that comes out of your faucet. This exchanger is activated by the incoming flow of water. So when you turn on your hot water tap, the incoming water circulates through the activated exchanger, which heats the cold water to your preset temperature. All you need then is some soap and shampoo and you're ready to wash, rinse and repeat.
Tankless systems come in two varieties -- point-of-use heaters and whole-house heaters. Point-of-use systems are small and only heat water for one or two outlets -- say, your kitchen sink. Because of their size, they can fit under a cabinet or in a closet. They're beneficial because they can be installed closer to your outlet and avoid water loss due to lag time. Lag time is the amount of time it takes for the hot water to reach your faucet. In large houses, the lag time can be significant, sometimes as long as several minutes. This means that while your water heating bill may be going down, your water consumption will be going up, which is something you should consider when debating whether or not to go tankless. Whole-house systems are larger, more expensive and can operate more than one outlet at a time.
With tankless water heaters, you can choose from electric, propane or natural gas models. Point-of-use models are generally electric, while whole-house systems are usually powered by either natural gas or propane. Which model to go with and what heating source you should use depends on many different factors. We'll take a closer look at those factors in the next section so you can make an educated decision when it comes time to purchase your tankless heater.